Before we get to the main idea, let’s quickly talk about what risk and reward are by themselves.
In trading, risk is the amount of money you could lose on a single trade. It's the maximum amount you are okay with losing if a trade doesn't go your way. Before you ever hit the "buy" or "sell" button, you should have a clear number in your mind. This is your safety net.
Think of it like this: If you are trading, you decide ahead of time, "I am only willing to lose $20 on this trade." That $20 is your risk. You manage this by using a special tool called a "stop loss." A stop loss is an automatic order that closes your trade for you if the price moves against you and hits your pre-set limit. This is how you protect your money from big losses. It’s like putting a fence around your money to keep it safe.
The reward is the opposite of risk. It’s the amount of money you hope to make if your trade is successful. This is your profit goal. You might say, "I want to make $60 on this trade." That $60 is your reward.
Just like with risk, there is a tool to help you here too. It's called a "take profit" order. This is another automatic order that closes your trade for you when the price reaches your profit goal. It helps you lock in your gains without having to watch the market all day long. This lets you stick to your plan and not get greedy or scared.
The risk reward ratio shows how much you're risking compared to how much you could gain. It's usually written like this: 1:2 or 1:3. This means for every $1 you risk, you're trying to make $2 or $3.
Let’s look at a simple example. If you enter a trade and you’re risking $10 to possibly earn $30, your risk reward ratio is 1:3. You’re putting $10 at risk in hopes of getting three times that amount.
A good risk reward ratio helps you:
- Trade with a plan, not on emotion
- Stay calm even when you lose
- Win more money over time, even with fewer winning trades
In short, your ratio helps you focus on the bigger picture. It helps you build a strategy that works over many trades, not just one.
Calculating your risk and reward ratio is a key step to becoming a smart trader. It’s a simple process that anyone can follow. Think of it as mapping out your trade before you take it.
Here’s how you do it, broken down into simple steps:
This is the exact price where you plan to enter the market. It’s where your trade will begin. You should have a reason for choosing this price based on your plan.
This is the price you decide you will exit the trade if things go wrong. It’s your safety net. You need to put your stop-loss at a logical place on the chart, where you would know for sure that your idea about the trade was incorrect.
This is the price where you will exit the trade if it goes your way. It's your finish line! Just like your stop-loss, you should place your take-profit at a logical spot on the chart where it makes sense to lock in your profit.
Now that you have your three prices, you can find the distance between them. In forex, we often talk about distance in "pips."
A pip is a small price movement, like a penny is a small movement for a dollar.
- Your Risk is the distance between your Entry Price and your Stop-Loss Price.
- Your Reward is the distance between your Take-Profit Price and your Entry Price.
Then, you just do the easy math: you divide your Reward by your Risk. The number you get is your
risk reward ratio.
Example: Imagine a trade where you set your prices like this:
- Entry: 1.1000
- Stop-Loss: 1.0970 (This is 30 pips away from your entry).
- Take-Profit: 1.1060 (This is 60 pips away from your entry).
Now, let's find the ratio:
Reward (60 pips) / Risk (30 pips) = 2
This means your ratio is 2, or as we write it, 1:2. It's a great setup! You are risking 1 unit of money to potentially win 2 units of money. This simple calculation gives you the confidence to know that the trade is a smart choice before you even begin.
Many new traders focus only on winning. They want every trade to be a win. But even expert traders lose trades. What sets the good ones apart is how they manage their losses.
With a good risk reward ratio, you can lose more trades than you win and still make money. Here’s how:
Let’s say you trade 10 times:
- You win 4 times and lose 6
- Your wins make $60 each
- Your losses cost you $20 each
That’s:
- 4 wins x $60 = $240
- 6 losses x $20 = $120
- Profit = $240 - $120 = $120
You lost more often than you won, but because your rewards were larger than your risks, you still came out ahead. That’s the magic of the risk reward ratio.
It also helps you stay calm. When you know you don’t need to win every time, you feel less stress. You focus more on following your plan and less on trying to be right all the time.
Let’s walk through a simple trade using a
risk reward ratio. Imagine you're
trading a currency pair like GBP/USD.
Entry: 1.3000
Stop-Loss: 1.2980 (This is 20 pips away from your entry, so your risk is 20 pips)
Take-Profit: 1.3040 (This is 40 pips away from your entry, so your reward is 40 pips)
This setup gives you a
1:2 ratio. You're risking 20 pips to try and gain 40 pips.
Now, let’s say you place five trades with this same setup:
- You win 2 trades: (+40 pips x 2 = 80 pips)
- You lose 3 trades: (-20 pips x 3 = 60 pips)
Your total gain is: 80 pips (from wins) - 60 pips (from losses) = +20 pips.
Even though you only won 2 out of 5 trades, you still made a profit. That’s the true power of a smart reward vs risk approach!
| Risk:Reward Ratio |
Risk |
Reward |
Break-Even Win Rate |
| 1:1 |
$100 |
$100 |
50% |
| 1:2 |
$100 |
$200 |
33.3% |
| 1:3 |
$100 |
$300 |
25% |
| 1:4 |
$100 |
$400 |
20% |
| 1:5 |
$100 |
$500 |
16.6% |
The idea of risk and reward is not just about a single trade. It's about your whole trading plan.
Here's a simple process to make this a habit:
- Before every trade, look at a chart.
- Find a good spot to put your "take profit" (your reward).
- Find a good spot to put your "stop loss" (your risk).
- Do the simple math to get your risk reward ratio.
- If the ratio is good (1:2 or better), think about the trade. If it's bad, just walk away. There will always be another chance.
- Finally, decide on your position sizing. This means figuring out how much money you will risk on this one trade. A good rule is to never risk more than 1% of your total trading money on any single trade. So, if you have $1,000, you would only risk $10. This is how you use your risk reward idea to manage your entire trading account.
By following this simple plan, you are not just trading. You are becoming a smart manager of your money. It's not about being lucky; it's about being prepared. You can't control the market, but you can control your risk and reward. That's the real secret to smart trading.
